INTRODUCTION TO COST ACCOUNTING

INTRODUCTION
If you set up a small manufacturing unit, say manufacturing of packing boxes, a problem will
arise what price of each box you should quote to the buyer. Many factors are considered while
fixing the price of a product/item such as competitors’ price etc. One of the basic factors is the
cost of its production. Cost is essential not only to fix price but also to ascertain the margin of
profit. Knowledge of the cost determination is also necessary to keep a check on the cost of
product/control on wastages, etc. The accounting used to study the various aspects of cost is
known as cost accounting

COST: MEANING AND ITS ELEMENTS

 The term ‘cost’ means the amount of expenses [actual or notional] incurred on or attributable
to specified thing or activity.
 Cost is ‘measurement in monetary terms of the amount of resources used for the purpose of
production of goods or rendering services.
 It can be expressed in terms of money; it means the amount of expenses incurred on or
attributable to some specific thing or activity.
 In reference to production/manufacturing of goods and services cost refers to sum total of
the value of resources used like raw material and labour and expenses incurred in producing
or manufacturing of given quantity

COST ACCOUNTING
 Cost accounting is the process of determining and accumulating the cost of product or
activity. It is a process of accounting for the incurrence and the control of cost. It also
covers classification, analysis, and interpretation of cost.
 In other words, it is a system of accounting, which provides the information about the
ascertainment, and control of costs of products, or services. It measures the operating
efficiency of the enterprise.
 It is an internal aspect of the organization

 Cost Accounting is accounting for cost aimed at providing cost data, statement and
reports for the purpose of managerial decision making.

SCOPE OF COST ACCOUNTING

Following functional activities are included in the scope of cost accounting:

 Cost book-keeping: It involves maintaining complete record of all costs incurred from
their incurrence to their charge to departments, products and services. Such recording is
preferably done on the basis of double entry system.
 Cost system: Systems and procedures are devised for proper accounting for costs.
 Cost ascertainment: Ascertaining cost of products, processes, jobs, services, etc., is the
important function of cost accounting. Cost ascertainment becomes the basis of
managerial decision making such as pricing, planning and control.
  Cost Analysis: It involves the process of finding out the causal factors of actual costs
varying from the budgeted costs and fixation of responsibility for cost increases.
 Cost comparisons: Cost accounting also includes comparisons between cost from
alternative courses of action such as use of technology for production, cost of making
different products and activities, and cost of same product/ service over a period of time.
 Cost Control: Cost accounting is the utilization of cost information for exercising
control. It involves a detailed examination of each cost in the light of benefit derived
from the incurrence of the cost. Thus, we can state that cost is analyzed to know whether
the current level of costs is satisfactory in the light of standards set in advance.

 Cost Reports: Presentation of cost is the ultimate function of cost accounting. These
reports are primarily for use by the management at different levels. Cost Reports form the
basis for planning and control, performance appraisal and managerial decision making.

OBJECTIVES OF COST ACCOUNTING

There is a relationship among information needs of management, cost accounting objectives, and
techniques and tools used for analysis in cost accounting. Cost accounting has the following
main objectives to serve:
• Determining selling price
The objective of determining the cost of products is of main importance in cost
accounting. The total product cost and cost per unit of product are important in deciding selling
price of product. Cost accounting provides information regarding the cost to make and sell
product or services. Other factors such as the quality of product, the condition of the market, the
area of distribution, the quantity which can be supplied etc., are also to be given consideration by
the management before deciding the selling price, but the cost of product plays a major role

 Controlling cost
Cost accounting helps in attaining aim of controlling cost by using various techniques
such as Budgetary Control, Standard costing, and inventory control.
Each item of cost [viz. material, labour, and expense] is budgeted at the beginning of the
period and actual expenses incurred are compared with the budget. This increases the efficiency
of the enterprise.
 Ascertaining costing profit
Cost accounting helps in ascertaining the costing profit or loss of any activity on an
objective basis by matching cost with the revenue of the activity.

 Providing information for decision-making

Cost accounting helps the management in providing information for managerial decisions
for formulating operative policies.
These policies relate to the following matters:
(i) Determination of cost-volume-profit relationship. (ii) Make or buy a
component
(iii) Shut down or continue operation at a loss
 (iv) Continuing with the existing machinery or replacing them by improved and
economical machines

 Facilitating preparation of financial and other statements

Cost accounting helps to produce statements at short intervals as the management may
require. The financial statements are prepared generally once a year or half year to meet the
needs of the management. In order to operate the business at high efficiency, it is essential for
management to have a review of production, sales and operating results. Cost accounting
provides daily, weekly or monthly statements of units produced, accumulated cost with analysis.
Cost accounting system provides immediate information regarding stock of raw material; semi-
finished and finished goods. This helps in preparation of financial statements.

BRANCHES OF ACCOUNTING
Accounting information can be classified broadly between financial accounting and
management accounting.

Financial accounting is the process of preparing financial statements that companies’ use to
show their financial performance and position to people outside the company, Including
investors, creditors, suppliers, and customers.

It is sometimes referred to as meeting the external accounting needs of the organization, and as
such is subject to many rules and regulations (a regulatory framework) imposed by company
legislation and accounting standards.

Management accounting is sometimes referred to as meeting the internal accounting needs of

the organization, as it is designed to help managers with decision making and planning. As such
it often involves estimates and forecasts, and is not subject to the same regulatory framework as
financial accounting

Or the process of preparing management reports and accounts that provide accurate and timely
financial and statistical information required by managers to make day-to-day and short-term
decisions.

DIFFERENCE BETWEEN FINANCIAL ACCOUNTING AND COST ACCOUNTING

Accounting can be defined is the process of identifying, measuring and communicating

economic information about an organization or other entity, in order to permit informed
judgments by users of the information.
 Simply as the recording, summarizing and interpretation of financial information.
Accounting is concern with providing both financial and non financial information that will help
decision makers to make a good decision
Cost accounting is a branch of management accounting and involves the application of various
techniques to monitor and control costs. Its application is more suitable to manufacturing
concerns

DIFFERENCES BETWEEN FINANCIAL ACCOUNTING AND MANAGEMENT

ACCOUNTING

FEATURES FINANCIAL FINANCIAL

ACCOUNTING MANAGEMENT
1.Objective Basic purpose is to prepare Designed to collect
profit and loss account and information about the
balance sheet to show optimum use of resources,
profitability and financial policy formation and control
position, respectively purposes.
2.source of principles Generally Accepted Flexible and Tailored to meet
Accounting Principles and the specific needs of
Practice of Accounting management
3. coverage Entire business entity Segments of business activity
or organization, as a whole
4.degree of accuracy As exact as possible, with Emphasis is on prompt and
emphasis on accuracy timely reporting, even if less
precise. Decision maker is
satisfied , if information is
correct to a large extent
5.data Mainly concerned with Mainly concerned with
presentation of data analysis of data
6.time span covered Concerned with the past data. Mainly concerned with future
So, it is said post- mortem so it supplies information
analysis of past activity both for the present and
future
7. Source of data Internal Both internal and external
8.legal compulsion Generally, there is legal There is no legal compulsion
compulsion totally optional
9. users Serves external users like Exclusively for internal use
shareholders, debentures
holders and financial
institutions.

IMPORTANCE OF COST ACCOUNTING

The limitation of financial accounting has made the management to realise the importance of
cost accounting. The importances of cost accounting are as follows:
 Helps in ascertainment of cost
Cost accounting helps the management in the ascertainment of cost of process, product,
Job, contract, activity, etc., by using different techniques such as Job costing and Process costing.
 Aids in Price fixation
 By using demand and supply, activities of competitors, market condition to a great extent,
also determine the price of product and cost to the producer does play an important role. The
producer can take necessary help from his costing records.
 Helps in Cost reduction
Cost can be reduced in the long-run when cost reduction programme and improved
methods are tried to reduce costs.
 Elimination of wastage
As it is possible to know the cost of product at every stage, it becomes possible to check
the forms of waste, such as time and expenses etc., are in the use of machine equipment and
material.
 Helps in identifying unprofitable activities
With the help of cost accounting the unprofitable activities are identified, so that the
necessary correct action may be taken.

 Helps in checking the accuracy of financial account

Cost accounting helps in checking the accuracy of financial account with the help of
reconciliation of the profit as per financial accounts with the profit as per cost account.
 Helps in fixing selling Prices
It helps the management in fixing selling prices of product by providing detailed cost
information.
 Helps in Inventory Control
Cost furnishes control which management requires in respect of stock of material, work
in progress and finished goods.
 Helps in estimate
Costing records provide a reliable basis upon which tender and estimates may be
prepared
 Importance to Employees
Worker and employees have an interest in which they are employed. An efficient costing
system benefits employees through incentives plan in their enterprise, etc. As a result both the
productivity and earning capacity increases.
 Cost accounting and creditors
Suppliers, investor’s financial institution and other moneylenders have a stake in the
success of the business concern and therefore are benefited by installation of an efficient costing
system. They can base their judgment about the profitability and prospects of the enterprise upon
the studies and reports submitted by the cost accountant.

 Importance to National Economy

An efficient costing system benefits national economy by stepping up the government
revenue by achieving higher production. The overall economic developments of a country take
place due to efficiency of production.
 Data Base for operating policy
Cost Accounting offers a thoroughly analyzed cost data which forms the basis of
formulating policy regarding day to day business, such as:
 Whether to make or buy decisions from outside?
 Whether to shut down or continue producing and selling at below cost?
 Whether to repair an old plant or to replace it?
ELEMENTS OF PRODUCT COST FOR MANUFACTURING COMPANIES

PRODUCT COST
Product cost refers to the costs used to create a product. These costs include direct labour, direct
materials, consumable production supplies, and factory overhead. Product cost can also be
considered the cost of the labour required to deliver a service to a customer. In the latter case,
product cost should include all costs related to a service, such as compensation, payroll taxes,
and employee benefits.
The cost of a product on a unit basis is typically derived by compiling the costs associated with a
batch of units that were produced as a group, and dividing by the number of units manufactured.
The calculation is:
(Total direct labour + total direct materials + Consumable supplies + Total allocated overhead) ÷
Total number of units
= Product unit cost
Product cost can be recorded as an inventory asset if the product has not yet been sold. It is
charged to the cost of goods sold as soon as the product is sold, and appears as an expense on
the income statement.

These are the elements of product cost which can be divided into three groups

 Material
 Labour
 Expense

MATERIAL
To produce or manufacture material is required. For example to manufacture shirts cloth is
required and to produce flour wheat is required. All material which becomes an integral part of
finished product and which can be conveniently assigned to specific physical unit is termed as
“Direct Material”. It is also described as raw material, process material, prime material,
production material, stores material, etc.

Actually, raw materials refer to any materials that are used in the final product; and the finished
product of one company can become the raw materials of another company. For example, the
plastics produced by X are a raw material used by Y in its personal computers.

Material is classified into two categories

 Direct material
 Indirect material

Direct material
Direct Material is that material which can be easily identified and related with specific product,
job, and process. Timber is a raw material for making furniture, cloth for making garments,
sugarcane for making sugar, and Gold/silver for making jewellery, etc are some examples of
direct material.

Indirect material
Indirect Material is that material which cannot be easily and conveniently identified and related
with a particular product, job, process, and activity. Consumable stores, oil and waste, printing
and stationery etc, are some examples of indirect material. Indirect materials are used in the
factory, the office, or the selling and distribution department.

LABOUR
Labour is the main factor of production. For conversion of raw material into finished goods,
human resource is needed, and such human resource is termed as labour. Labour cost is the main
element of cost in a product or service. Labour can be classified into two categories:

 Direct Labour, and

 Indirect labour

Direct labour
Labour which takes active and direct part in the production of commodity. Direct labour is that
labour which can be easily identified and related with specific product, job, process, and activity.
Direct labour cost is easily traceable to specific products.
Cost of wages paid to carpenter for making furniture, cost of a tailor in producing readymade
garments, cost of washer in dry cleaning unit are some examples of direct labour.

Indirect labour
Indirect labour is that labour which cannot be easily identified and related with specific product,
job, process, and activity. It includes all labour not directly engaged in converting raw material
into finished product. Wages of store-keepers, time-keepers, salary of works manager, salary of
salesmen, etc, are all examples of indirect labour cost.

EXPENSES
All cost incurred in the production of finished goods other than material cost and labour cost are
termed as expenses. Expenses are classified into two categories
 Direct expenses, and
 Indirect expenses (An item of overheads)

Direct expenses
These are expenses which are directly, easily, and wholly allocated to specific cost centre or cost
units. All direct cost other than direct material and direct labour are termed as direct expenses.
Direct expenses are also termed as chargeable expenses. Some examples of the direct expenses
are hire of special machinery, cost of special designs, moulds or patterns, feed paid to architects,
surveyors and other consultants, inward carriage and freight charges on special material, Cost of
patents and royalties.

Indirect expenses
These expenses cannot be directly, easily, and wholly allocated to specific cost centre or cost
units. All indirect costs other than indirect material and indirect labour are termed as indirect
expenses

Indirect expenses are treated as part of overheads. Rent, rates and taxes of building, repair,
insurance and depreciation on fixed assets, etc, are some examples of indirect expenses

MANUFACTURING OVERHEADS

Manufacturing overhead is all of the costs that a factory incurs, other than the variable costs
required to build products, such as direct materials and direct labour.
 Manufacturing overhead includes items such as indirect materials; indirect labour;
maintenance and repairs on production equipment; and heat and light, property taxes,
depreciation, insurance on manufacturing facilities and indirect expenses.
 A company also incurs costs for heat and light, property taxes, insurance, depreciation,
and so forth, associated with its selling and administrative functions, but these costs are
not included as part of manufacturing overhead.
 Only those costs associated with operating the factory are included in manufacturing
overhead.

CLASSIFICATION OF COST
Classification of cost is the arrangement of items of costs in logical groups having regard to their
nature or purpose. Items should be classified by one characteristic for a specific purpose without
ambiguity. OR
 Classification is the process of grouping costs according to their common characteristics
or features. There are various methods of classifying costs on the basis of requirements.

Scheme of classification should be such that every item of cost can be classified the basis for
cost classification is as follows:
(a) Nature/Elements of expense
(b) Functions / Activities
(c) Behaviour – Fixed, Semi-variable or Variable
(d) Association with the Product
(e) Time

(a) Classification by Nature/Elements of Expense

Costs should be gathered together in their natural groping such as Material, Labour and Other
Direct expenses. Items of costs differ on the basis of their nature. The elements of cost can be
classified in the following three categories. 1. Material 2.Labour 3. Expenses
Material Cost: Material cost is the cost of material of any nature used for the purpose of
production of a product or a service. It includes cost of materials, freight inwards, taxes & duties,
insurance ...etc directly attributable to acquisition, but excluding the trade discounts, duty
drawbacks and refunds on account of excise duty and vat.
Labour Cost: Labour cost means the payment made to the employees, permanent or
temporary for their services. Labour cost includes salaries and wages paid to permanent
employees, temporary employees and also to the employees of the contractor. Here salaries and
wages include all the benefits like provident fund, gratuity, ESI, overtime, incentives...etc
Expenses: Expenses are other than material cost or labour cost which are involved in an activity.
They can be further subdivided into direct and indirect material cost, direct and indirect labour
cost and direct and indirect other expenses
(b) Classification by Functions:
A business enterprise performs a number of functions like manufacturing, selling, research...etc.
Costs may be required to be determined for each of these functions and on this basis functional
costs may be classified into the following types:-
(i) Production or Manufacturing Costs
(ii) Administration Costs
(iii) Selling & Distribution cost
(iv) Research & Development costs

(i)Production or Manufacturing Costs: Production cost is the cost of all items involved in the
production of a product or service. These refer to the costs of operating the manufacturing
division of an undertaking and include all costs incurred by the factory from the receipt of raw
materials and supply of labour and services until production is completed and the finished
product is packed with the primary packing.
The followings are considered as Production or Manufacturing Costs:-
(1) Direct Material
(2) Direct Labour
(3) Direct Expenses and
(4) Factory overhead,
(ii)Administration Costs: Administration costs are expenses incurred for general management
of an organization. These are in the nature of indirect costs and are also termed as administrative
overheads. For understanding administration cost, it is necessary to know the scope of
administrative function.
Administrative function in any organization primarily concerned with following activities:-
(1) Formulation of policy
(2) Directing the organization and
(3) Controlling the operations of an organization. But administrative function will not include
control activities concerned with production, selling and distribution and research and
development. Therefore, administration cost is the cost of administrative function, i.e., the cost
of formulating policy, directing, organizing and controlling the operations of an undertaking
(Administrative cost will include the cost of only those control operations which are not related
to production, selling and distribution and research and development). In most of the cases,
administration cost includes indirect expenses of following types:
 Salaries of office staff, accountants, directors
 Rent, rates and depreciation of office building
 Postage, stationery and telephone
 Office supplies and expenses
 General administration expenses.

(iii)Selling & Distribution Costs: Selling costs are indirect costs related to selling of products
are services and include all indirect costs in sales management for the organization. Distribution
costs are the costs incurred in handling a product from the time it is completed in the works until
it reaches the ultimate consumer. Selling function includes activities directed to create and
stimulate demand of company’s product and secure orders. Distribution costs are incurred to
make the saleable goods available in the hands of the customer.
Following are the examples of selling and distribution costs:
 Salaries and commission of salesmen and sales managers.
 Expenses of advertisement.
 Rent, rates, depreciation and insurance of sales office and warehouses.
 Cost of insurance, freight, export, duty, packing, shipping, etc.,
 Maintenance of Delivery vans.
(iv)Research &Development Costs:Research & development costs are the cost for undertaking
research to improve quality of a present product or improve process of manufacture, develop a
new product, market research...etc. and commercialization thereof.
R&D Costs comprises of the following:-
 Development of new product.
 Improvement of existing products.
 Finding new uses for known products.
 Solving technical problem arising in manufacture and application of products.
 Development cost includes the costs incurred for commercialization / implementation of
research Findings

(c)Classification based on Behaviour – Fixed, Semi-variable or Variable

Costs are classified based on behaviour as fixed cost, variable cost and semi-variable cost
depending upon response to the changes in the activity levels.
Fixed Cost: Fixed cost is the cost which does not vary with the change in the volume of activity
in the short run. These costs are not affected by temporary fluctuation in activity of an enterprise.
These are also known as period costs. Example: Rent, Depreciation...etc.
Variable Cost: Variable cost is the cost of elements which tends to directly vary with the
volume of activity. Variable cost has two parts (i) Variable direct cost (ii) Variable indirect costs.
Variable indirect costs are termed as variable overheads. Example: Direct labour, Outward
Freight...etc.
Semi-Variable Costs: Semi variable costs contain both fixed and variable elements. They
are partly affected by fluctuation in the level of activity. These are partly fixed and partly
variable costs and vice versa. Example: Factory supervision, Maintenance...etc
(d)Association with the Product: Cost can be classified as product costs and period costs.
Product costs are those which are traceable to the product and included in inventory cost, thus
Product cost is full factory cost.
Period costs are incurred on the basis of time such as rent, salaries etc. thus it includes all selling
and administration costs. These costs are incurred for a period and are treated as expenses

(e) By Time: Costs can be classified as 1) Historical cost and 2) Predetermined Costs.
The costs which are ascertained and recorded after it has been incurred are called historical
costs.
They are based on recorded facts hence they can be verified and are always supported by
evidences.

Predetermined costs are also known as estimated costs as they are computed in advance of
production taking into consideration the previous periods’ costs and the factors affecting such
costs.
WHAT IS A COST STATEMENT
A document that reflects the cost of the items and services required by a
particular project or department for the performance of its business purposes

For example, a departmental cost sheet might include the material costs, labour
costs and overhead costs incurred over a given time frame by a department and it
therefore provides a record of costs that are chargeable to that department
As businesses take on new projects and run their day-to-day operations, they need to track how
much they spend along the way.
A cost statement or cost sheet provides management a document that details the costs of
conducting a project, running a department or manufacturing a product in terms of goods and
services.
Most cost sheets contain a minimum of three primary sections labelled direct materials, direct
labour and overhead. Some cost sheets include sections such as indirect labour, which covers
support staff, and indirect materials, which represent a negligible expense.

STATEMENT OF A MANUFACTURING
 Manufacturing company is the company that focus on using labour and/or machinery to
convert raw materials into marketable products, while merchandising company is a
commercial enterprise dedicated to the purchase of finished goods and their resale for a
profit.
 A merchandising business will generally buy their products from a wide range of
distributors domestically and internationally and market their products in huge consumer
shopping facilities.

THE COST OF GOODS MANUFACTURED STATEMENT

The purpose of the cost of goods manufactured statement is to compute the cost of goods
completed or finished in a given time period.
The cost of goods manufactured is the cost of goods finished this period. Cost of goods
manufactured consists of three basic cost elements: (1) materials, (2) factory labour, and (3)
manufacturing overhead. Materials used are a computation:
Direct material means cost of raw material used or consumed in production. It is not necessary
that all the material purchased in a particular period is used in production. There is some stock of
raw material in balance at opening and closing of the period. Hence, it is necessary that the cost
of opening and closing stock of material is adjusted in the material purchased. Opening stock of
material is added and closing stock of raw material is deducted in the material purchased and we
get material consumed or used in production of a product

Adjustment for stock of work-in-progress

In the process of production, some units remain to be completed at the end of a period. These
incomplete units are known as work-in-progress. Normally, the cost of incomplete units includes
direct material, direct Labour, direct expenses, and average factory overheads. Hence, at the time
of computing factory cost, it is necessary to make adjustment of opening and closing stock of
work in progress to arrive at the net Factory cost/works cost.

Example 1
1 January 20X7, Stock of raw materials 8,000
31 December 20X7, Stock of raw materials 10,500
1 January 20X7, Work in progress 3,500
31 December 20X7, Work in progress 4,200

Year to 31 December 20X7:

Wages: Direct 39,600
Indirect 25,500
Purchase of raw materials 87,000
Fuel and power 9,900
Direct expenses 1,400
Lubricants 3,000
Carriage inwards on raw materials 2,000
Rent of factory 7,200
Depreciation of factory plant and machinery 4,200
Internal transport expenses 1,800
Insurance of factory buildings and plant 1,500
General factory expenses 3,300

Required
 a) Find the Production cost of goods completed / the cost of goods manufactured
b) also there had been £3,500 stock of finished goods at 1 January 20X7 and £4,400 at 31
December 20X7, and the sales of finished goods amounted to £250,000 then prepare the
trading account /manufacturing account

Example 2
The following figures are taken from the books of a manufacturing company for the year ended
on March 31, 2017. Prepare a cost sheet showing clearly the prime cost, production cost, total
cost (statement of cost of production) and profit obtained

Details this Details THz

Direct material 2,500,000 Branch office expenses 30,000
Direct labour 800,000 Depreciation of office building 10,000
Depreciation of factory Deprecation of staff cars 15,000
building 16,000 Electricity (including tshs 5,000)
Insurance: for administrative office) 35,000
Staff cars 2,000 Advertisement 18,000
Office building 1,500 Sundry factory expense 420,000
Factory building 2,000 Sales promotion 4,000
Delivery van-maintenance Office administration expenses 60,000
and running expenses 12,000 Expenses for participating in
Salaries (including that of industrial exhibition 8,000
sales manager tshs 20,000
and factory chief engineer Sales (10,000 units)
tshs 25,000) 275,000 Units produced (10,000)
Finished goods warehouse Price 500/unit
expenses 15,000

Formula
 Cost of Goods Manufactured Statement
 Material used = materials (beginning) + material purchases - materials inventory (ending)
 Cost of goods manufactured = materials used + factory labour + manufacturing overhead
+ work in process (beginning) - work in process (ending)
 Income statement
 Cost of goods sold = finished goods (beginning) + cost of goods manufactured - finished
goods (ending)
 Overhead = Indirect material + Indirect labour + Indirect expenses